Latvia’s Economic Potential: Recovery and Reforms

Latvia’s economy has attracted international attention out of all proportion to its size. Many observers know that Latvia returned to strong economic growth after a severe downturn in 2008 and 2009 and a tough austerity program. In late 2012, Latvia even repaid the IMF in full, several years early.

But the international consensus ends there. Critics of Latvia’s economic strategy point to continuing high rates of unemployment and poverty; advocates point to the benefits of frontloading spending cuts and tax increases to lay the foundations for recovery.

What happened in 2008 and 2009 needs to be seen in the context of what went wrong before.

At first glance, Latvia’s economic performance between 2004 and 2007—real GDP growth averaging 10 percent annually—seemed like a tour de force. But it was a steroid-fueled performance. Credit flowed freely and asset prices boomed. Average wage growth reached 20 to 30 percent annually, far outrunning productivity. And the government of the day spent the boom-related increases in revenue—from the cyclical perspective, at exactly the worst time. The headline fiscal deficit stayed low but the structural fiscal position weakened. Latvia ran up massive current account deficits of over 20 percent of GDP in 2006 and again in 2007. So when the global crisis struck Latvia in 2008, the wheels came off.

Latvia’s response—sticking to the long-standing exchange rate peg to the euro, and implementing a fiscal adjustment of over 15 percentage points of GDP—also needs to be seen in the context of two more country-specific facts:

Latvia’s financial system is already very highly “euroized”. When Latvia requested its EU-IMF loan in 2008, some 70 percent of bank deposits and nearly 90 percent of loans were in foreign currency, mainly euros.

Since then, the economy has been recovering steadily. Latvia stuck to its economic policy course. External and structural fiscal imbalances that had ballooned before the crisis have been brought back under control.

We will know in coming months whether Latvia will qualify to adopt the euro in 2014. For a country that kept its peg to the euro even under severe strain in 2008 and 2009—and whose people earn wages and pay day-to-day bills in local currency but save, borrow, and pay for mortgages in euros—the economic case for euro adoption is strong.

Latvia is stable again. But things aren’t perfect. The unemployment rate has fallen to between 13–14 percent: well down from the peak, but still high even allowing for emigration.

Is Latvia’s economic activity back in line with its potential? Is still-high unemployment structural or cyclical?

After years of economic policy discipline and reform efforts, what further microeconomic reforms could support sustainably higher growth?

We find that Latvia still has a negative output gap of about 2½ percent of potential output. This is much closer to balance than before. Latvia swung from overheating (positive output gap) of up to 10 percent before the crisis, to a slump (negative output gap) of some 13 percent in 2009. We also estimate Latvia’s rate of unemployment if the economy is neither overheating nor slumping—the non-accelerating inflation rate of unemployment—at around 12–13 percent. The analysis finds the rate would have been fairly steady over the past few years, even taking into account some hysteresis—that is, when unemployment persists and becomes permanent—in 2011 and 2012.

This means that the high level of unemployment in Latvia is largely structural (it’s not about the cycle). At the same time, it is true that the increase in unemployment through the crisis was largely cyclical. Why does this add up? Because when the unemployment rate fell below 6 percent in 2007, it couldn’t last: the economy was badly overheating at the time.

Our paper also focuses on three areas where sectoral reforms could bear most fruit: improving the efficiency of the legal system, including curbing abuses of the insolvency procedures; improving governance and transparency of state-owned enterprises, and upgrading the quality of vocational and higher education. The good news: the authorities also recognize the case for reform in these areas, and are planning accordingly. But implementation largely lies ahead.

From the perspective of higher growth, employment, and living standards, it will be implementation that matters. A more efficient legal system would improve the business environment and promote investment. An education sector that better responds to the needs of employers would boost productivity and reduce skills mismatches. And tax-benefit reforms could promote incentives to work, consistent with a safety net that adequately protects the poorest—an IMF concern throughout the program.

The policy debate on Latvia has so far tended to focus on how the country dealt with its crisis and regained its stability, at a high price. We hope more attention can now turn to how Latvia can promote economic growth in the future. But this time, growth not fueled by fiscal or financial doping, but underpinned by quality microeconomic reforms whose results can endure.

From the perspective of higher growth, employment, and living standards, it will be implementation that matters. David Moore

Austerity paid off well so that Latvia could pay IMF loans ahead of time, but still structural deficiencies have taken their toll in the shape of unemployment, output gaps, needed improvement in governance and efficiency to run he state owned enterprises. In fact, as David Moore has insisted, there is an urgent need to implement the structural reforms to gain long term results.